MJ Hudson regularly surveys the terms of private equity and venture capital fund agreements (where we are acting for either the fund manager or prospective investors) to get a sense of how private fund terms are evolving. Following is a digest of key findings from our analysis of a large, diverse sample of funds that achieved their first closing during the course of 2015.
The 10-plus-2-year model remains standard for the fund’s term, but there is greater diversity in the market now, particularly at the shorter end. So there are a number of funds closing with initial terms of five-to-seven years. Some of the factors behind this development include:
- The manager has pre-selected investments for the fund to acquire (so the fund only needs an abbreviated investment period).
- The fund’s investment strategy is focused on buying mature assets (so it can expect to see exits sooner rather than later).
- The fund is led by an emerging manager seeking to establish its track record (so it is willing to offer more LP-friendly terms).
- Generally speaking, investors’ growing reluctance to lock their money up for a decade or more.
General disclosure of individual investor side letters has long been a standard term of private equity funds. In addition, under a Most Favoured Nations (MFN) clause, an investor is typically afforded the opportunity to benefit from terms in any other investor’s side letter – or, in a ‘tiered’ MFN, it would at least receive the same terms offered to any investor who has invested the same or less.
But this level of transparency is declining:
- Only 35% of LPAs in our survey contained a traditional MFN clause.
- There is a growing trend to insert ‘tiers’ into not just the MFN but also disclosure itself, i.e. the right to see an investor’s side letter is restricted to those investors who have subscribed at least the same commitment.
This development is of particular detriment to smaller investors, and it remains to be seen if European regulators or investors will counteract it by invoking the AIFMD (which requires disclosure of preferential treatment to investors generally).
The average management fee in our fund sample (assessed as a percentage of fund commitments) is closer to 1.5%. But it is a relatively small number of large-cap funds that tend to charge fees below 2%, thus pulling the average down with them. It is much more common for managers (especially at smaller-cap funds) to set management fees at the historical norm of 2%.
We also see a developing trend toward offering discounts to select investors – for instance, “early bird” investors (i.e. first-closers) pay a reduced management fee compared to investors entering the fund in later closings. Discounts are also sometimes offered to investors making big commitments. However, it is worth noting that discount mechanics of this sort tend to be found in funds with over $5 billion in commitments.
We continue to see pressure on managers to put ‘skin in the game’ above the widely-accepted 1% of total commitments. In a large majority of funds in our survey, the GP had made bigger commitments, ranging from 1.5% to as much as 5%. But an important caveat to this seemingly LP-favourable shift is the availability of options to managers looking to finance their commitment, which include:
- Management fee waivers
- Bank lending to the GP
- Contribution of assets of an equivalent value in lieu of cash
It is also worth investors considering who is actually being required to put in the GP commitment. The funds in our survey often defined the GP class broadly – so the commitment often may not be funded entirely by the actual managers.
Hurdle rate and carries interest
Our survey shows that the 8% preferred return hurdle is still widely used. 93% of capital deployed had a hurdle of 8%, with a very small proportion (0.2%) offering a higher hurdle, and only 6% with a lower preferred return. 20% carried interest also remains the industry standard – 78% of funds analysed had an 80/20 profit split.
But we are increasingly seeing a balance being struck between management fee and carry levels. The research also showed that carry levels of less than 20% typically are offered as part of an early bird discount and carry levels above 20% tend to be scaled, where the carry increases as higher return hurdles are met.
There is a longstanding split between U.S. and European funds with regards to how carried interest is distributed:
- US funds typically use deal-by-deal carry structures, which are GP-friendly because individual investments can get into carry much more quickly, even if the fund does not perform well overall.
- In Europe, funds implement whole-fund carry structures, where carry is calculated on the fund’s returns as a whole.
This distinction continues to hold true. 80% of the U.S. funds we surveyed used deal-by-deal, while two-thirds of European funds used some variant of whole-fund. But the interesting development is the rise in whole-fund carry in the U.S. – one in five American funds in our survey used it. This suggests that investor lobbies like ILPA (which recommends whole-fund carry) may be having an impact across the Atlantic.
All funds analysed contained Key Executive triggers. 87% of funds imposed an automatic suspension of fund investing when the Key Executive is triggered, with 94% providing for automatic termination of the investment period post-suspension if no replacement Key Executive is approved.
This sounds all very investor-friendly, but in a large number of funds their effect is limited in a variety of ways, for instance:
- The amount of time and effort required to be committed by Key Executives is defined only very loosely;
- Key Executives are not required to commit their time just to the fund in question, but more widely to the management company, other funds or products (e.g. managed accounts), or even to outside business, political or charitable activities.
Our research appears to show a slight shift of key terms in investors’ favour, particularly on management fees, carry distribution and the size of GP commitments. However, LP-friendly terms aren’t always as strong as they first appear, e.g. funding GP commitment through management fee waivers, or the limited circumstances in which Key Executive protections can be triggered.